marketss: Out of the Blue
New York: June 23, 2008
By John R. Stephenson

It was a shot out of the blue and from the most unlikely of places — China. The country that has been the driving force in the global commodity boom was going to impose an immediate 18% increase at the gas pump. On the news, crude oil took a tumble, as investors feared that Chinese demand might cool in the face of sharply higher retail gasoline prices. The fears have turned out to be short-lived, but investors are still left wondering is it over ?

So far, commodities and the stocks of commodity producing companies have been one of the few things working in this market. The U.S. economy is slumping, but the surging economies of India and China have kept commodity prices heading higher.

Or have they? Sure, corn and soybean prices are up, but nickel and zinc prices have tumbled. Ag stocks are up, but base metal stocks are down. Oil prices are up, but demand in the West has finally turned negative. So what gives?

Lots. China has slowed its demand for nickel (used primarily in stainless steel) and zinc while the slowing economies of the West have left traders skeptical of a further rally in the base metals. So far, only agricultural commodities (wheat, soy, corn etc.) and oil seem impervious to the broadening economic slowdown.

The implications for investors of these "two" markets have been profound. For more than a year now, the S&P500 Stock Index is playing a distant second to the commodity-heavy Toronto Stock Index ("TSX"). With shares of energy and materials stocks (51% of total index weight) on a tear, the TSX is on a roll.

Figure 1: Not All Stock Markets are Created Equal!

Source: First Asset Investment Management, Inc.

But the recent decision from China brings up a worrisome thought. What if massive commodity inflation slowed economic growth globally? Could we end up in a situation where nothing is working in our portfolios? Perhaps!

But that is unlikely. Food inflation is here to stay, primarily since eating is one activity that isn't optional, whereas, in many cases, driving is. And food and fuel inflation is causing massive inflationary forces globally, which threaten the health of the broad economy and the stock market. India, for example, is facing inflation of 11%. China, with their recent gasoline hike is also experiencing strong inflationary forces that may crimp the commodity growth engine over time.

Even though we have seen meteoric rises in the prices for agricultural commodities, we have yet to see demand explode (annual demand is growing at 3.5% a year), suggesting that supply may be more of deterrent to lower food prices than demand. The U.S. Midwest, which is the Saudi Arabia of corn, has experienced 17 straight years of record harvests. With floods and bad weather delaying the planting season, it is almost a certainty that this year's harvest is going to be worse than usual.

And that means higher food prices. Soybean and corn prices in the short-term are almost entirely driven by weather. Favorable weather generally results in a better harvest and ample supplies which keep a lid on prices. Throw in a little bad weather and couple that with the fact that global grain supplies are at their lowest levels in recorded history and the possibility exists for further dramatic price increases in grains.

If grain prices keep making their steady march higher, then world governments will have little choice but to see to it that their people are fed. And that could mean delaying or putting off altogether other important economic projects. While it is somewhat doubtful, investors could be in the perverse situation of having only their agricultural stocks on a tear while the rest of their portfolio is circling the drain.

So far, the food processors and food packers such as Tyson Foods have been having a rough time. They have little choice so far but to absorb the steadily rising prices for grains, which has put tremendous pressure on their margins. Many of the food producers are in a dire financial situation and some may go bankrupt. But this will set up a wave of consolidation in the industry and allow for cost pass through to consumers and eventually higher margins. This could soon be the go-to sector in the agricultural space.

For now, investors should continue to do more of what is working. For our money, we continue to favor oil and gas companies with current or near-term production as well as fertilizer stocks as core positions for our portfolios.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article